International Monetary Fund Washington, D.C.

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1 2012 International Monetary Fund March 2012 IMF Country Report No. 12/66 January 2012 January 29, 2001 January 29, 2001 January 29, 2001 January 29, 2001 Mexico: Detailed Assessment of Observance of Basel Core Principles This paper was prepared based on the information available at the time it was completed in March The views expressed in this document are those of the staff team and do not necessarily reflect the views of the government of Mexico or the Executive Board of the IMF. The policy of publication of staff reports and other documents by the IMF allows for the deletion of market-sensitive information. Copies of this report are available to the public from International Monetary Fund Publication Services th Street, N.W. Washington, D.C Telephone: (202) Telefax: (202) Internet: International Monetary Fund Washington, D.C.

2 FINANCIAL SECTOR ASSESSMENT PROGRAM MEXICO BASEL CORE PRINCIPLES DETAILED ASSESSMENT OF OBSERVANCE MARCH 2012 INTERNATIONAL MONETARY FUND MONETARY AND CAPITAL MARKETS DEPARTMENT THE WORLD BANK FINANCIAL SECTOR VICE PRESIDENCY LAC REGION VICE PRESIDENCY

3 2 Contents Page Executive Summary...3 I. General...7 A. Information and Methodology Used for Assessment...7 B. Previous FSAP BCP Assessment...8 C. Principle-by-Principle Assessment...13 Tables 1. Summary Compliance of the Basel Core Principles Detailed Assessment of Compliance with the Basel Core Principles Recommended Actions Box 1. Actions Undertaken to Implement Recommendations of the 2006 FSAP Update...9

4 3 EXECUTIVE SUMMARY The effectiveness of banking supervision in Mexico has helped to reduce the impact of the global financial crisis on the financial sector. The Comision Nacional Bancaria y de Valores (CNBV) has achieved a fundamental step forward in implementing a complete Pillar I capital adequacy regime that is consistent with the Basel Committee standards. Capital ratios have remained strong and above the regulatory minimum, supported by a rigorously applied forward-looking loan provisioning regime. The CNBV has successfully supervised adherence to the above two crucial regimes and developed robust means to quantify and monitor key risk measures. Since the last FSAP Update in 2006, the CNBV has made steady progress in advancing a major internal reorganization. Its supervisory culture is now much more risk focused. Its internal organization visualizes supervision according to institutional, group, and risk dimensions. Systemic supervision is being set up. Progress is also noticeable in the practices applied by the CNBV. The professionalism and quality of its management, and of the staff dedicated to supervision, are outstanding. It has put in place rich offsite systems for supervision and is implementing changes toward a risk-based approach. However, crucial challenges remain ahead to preserve and to project forward what has already been achieved. Important institutional issues outside the control of senior management in the CNBV threaten the sustainability of the above achievements. These issues constrain the ratings assigned by the assessors to several principles. The autonomy, the authority, and the resources of the CNBV remain limited. The CNBV is still an agent of the Executive, with 10 out of 13 positions in the Board being under the control of the Executive (Secretaria de Hacienda y Credito Publico, SHCP). In addition, most of the CNBV s key decisions 1 belong to its Board. The Board needs to provide more leadership to the CNVB, as required for a modern supervisory agency. The lack of autonomy in funding its activities and in providing more competitive salaries is eroding the key element of supervision: its people. High staff turnover related to below-market salaries has been a particular concern for maintaining the quality of supervision and institutional continuity. Headcount seems excessive, but management cannot flexibly restructure the agency (due in part to unionized civil service staff) to meet its needs and make better use of its decreasing budgetary resources. There is also a proliferation of new institutions to supervise and an ever-increasing universe of compliance requirements that make CNBV s workload particularly heavy. 1 Per the count made by the assessors, 31 key decisions belong to the CNBV s Board without delegation, and an additional 12 decisions require consultation with the Banco de Mexico (BoM).

5 4 There is no appropriate statute covering the terms of service for CNBV s senior management and legal protection for its staff. Members of its senior management team do not have a fixed term contract and there are no specific rules for their removal. In addition, no specific legal protection is given to CNBV s managers and supervisory staff for the decisions taken in good faith. This, together with the lack of flexibility and budget aligned to its increasing needs, constrains the effectiveness of the CNBV. Moreover, in a civil code environment, it is easier to take appropriate measures (either external action or an official reprimand) on the basis of noncompliance rather than mere judgment, as a responsible response to risk accumulation. There is no way forward to resolve these issues without making CNBV more independent operationally and providing further flexibility to its management. 2 Pillar 2 of the capital adequacy regime remains to be adopted, including publication of CNBV s supervisory review process and associated standards. The strategic decision to adopt Basel II and a more risk-based approach to supervision makes it critical to resolve the issues discussed on autonomy and resources. Until now, the CNBV has focused on implementing the quantification of Pillar 1 risks and has advanced several internal elements of its supervisory review process under Pillar 2. However, several supervisory practices and associated standards deserve attention to complete Pillar 2 and the effectiveness of the riskbased approach being adopted. These issues include: The institutions need to be mandated to perform an internal capital adequacy assessment process (ICAAP) to determine how much capital they need going forward and the strategies and means to obtain that capital and keep it aligned to their risk profile; 3 The CNBV needs to make public its supervisory review and evaluation process (SREP) to build upon the ICAAP and to determine the sufficiency of Pillar 1 and Pillar 2 risk capital estimated by bank management, including whether and how to require additional capital; 4 The standards to implement Pillar 2 have to be improved or completed for liquidity risk (soon to be adopted), and for concentration and interest rate risks. Further attention needs to be given to the treatment of risks from association with broader 2 These issues explain the materially noncompliant rating assigned to CP1. 3 The lack of a mandated ICAAP explains the largely compliant rating assigned to CP7 on risk management, and to CP19 on supervisory approach. 4 The lack of a complete internal SREP and its publication explains the largely compliant rating assigned to CP19 on supervisory approach.

6 5 mixed-activity conglomerates, which some Mexican banks and financial groups are members of; 5 CNBV should design and implement a supervisory cycle to cover in-depth all significant activities and central control functions of institutions and groups. This assessment should prompt a re-assessment of the workload associated with these tasks, to estimate and to secure anticipated staff resources in terms of number and seniority/experience; 6 Compliance with regulation is not sufficient to maintain financial stability. The CNBV needs to pursue strategies directed at reducing the risk profile of adversely rated institutions, as well as to respond to the lack of progress by their Boards and senior managers in addressing CNBV s concerns. Progress in implementing these strategies provides the basis for judging the overall performance and effectiveness of supervision following an objective quality assurance process; 6 The criteria and procedures, including risk metrics, used internally to assess risk and conduct inspections need integration and standardization among the CNBV s internal units. In particular, more guidance is needed, as well as risk benchmarks, to evaluate business models and the effectiveness of management and controls, as the best forward-looking indicators of risk; 6 and CNBV needs to strengthen the basis for enforcing qualitative issues related to sound and safe practices. It also needs to make Boards aware of their fiduciary responsibilities in ensuring adherence to such practices and of the seriousness of breaches of regulatory compliance. 7 Once that has been achieved, the CNBV will have reached its risk-based destination. Further actions are recommended to strengthen a robust regime for downward consolidated supervision of banking groups. There are 25 financial groups regulated by the SHCP being supervised by the CNBV. Asymmetries in the regulations across financial subsectors have been evaluated and need now to be addressed. The CNBV should be given powers to regulate all financial groups where banks are significant members. Prudential regulation, especially risk limits, and risk governance and management standards should be 5 The lack of complete regulations, and of risk management and supervisory standards, for these risks explains the largely compliant ratings assigned to CP14 on liquidity risk, CP16 on interest rate risk, CP19 on supervisory approach, and CP24 on consolidated supervision. Moreover, issues identified in CP10 on large exposures and CP11 on related party lending limits need further consideration. 6 These items explain the largely compliant ratings assigned to CP19 and to CP23. 7 This, and further aspects discussed in this assessment, explain the largely compliant rating assigned to CP23 on remedial actions.

7 6 extended to the level of the holding company in regulated groups. More importantly, mixedactivity groups that combine banking and other financial activities with commercial activities have to be regulated, providing effective powers to the CNBV to assess and resolve risks to banking and other financial activities from inter-group transactions. 8 These actions will complete current consolidated supervision practices, reinforcing the CNBV s authority to practice upward group consolidated supervision. The assessment found other areas where the regulatory and supervisory framework should be further improved. Anti-money laundering (AML) supervision has been substantially strengthened. However, challenges remain and key decisions need to be made to bring Mexico to a higher level of compliance with international standards. The use of enforcement should become more focused in responding to substantive issues rather than reacting solely to breaches of compliance. Moreover, whilst operational risk is well regulated, its supervision is not yet fully operational and needs to be performed more systematically at both macro and solo levels, including the systematic development of risk indicators. 9 Like for other risks, the assessors believe that there is a general need to provide further guidance to the industry regarding how the CNBV expects institutions to implement the mandated prudential standards in practice. Such guidance would constitute a clear communication of the supervisory process and of how the CNBV intends to strengthen its response to changing risk profiles. This will complete the CNBV s new approach that judiciously combines elements of compliance, safety and soundness, and risk-based consolidated supervision. 8 These issues discussed in the report of assessment constrain to largely compliant the ratings assigned to CP24 on consolidated supervision. 9 These issues explain the largely compliant ratings assigned to CP18 on AML, CP23 on enforcement, and the materially noncompliant rating to CP15 on operational risk.

8 7 I. GENERAL 1. This detailed assessment of the current state of implementation of the Basel Core Principles in Mexico has been completed as part of a Financial Sector Assessment Program update undertaken jointly by the International Monetary Fund and the World Bank. The assessment was conducted in September 2011 to update the 2006 assessment. 10 It reflects the banking supervision practices of the country as of end-july The ratings assigned during this assessment are not necessarily directly comparable to the ones assigned using the pre-2006 BCP Methodology. Moreover, the bar to measure the effectiveness of a supervisory framework was raised following the recent financial crisis. A. Information and Methodology Used for Assessment 2. The assessment is based on several sources: (i) a self-assessment in August 2011 by the country authorities, including written answers to an exhaustive questionnaire; (ii) detailed interviews with staff from the relevant national agencies, including the CNBV, the central bank of Mexico (BoM), the SHCP, and the Financial Intelligence Unit (UIF); (iii) relevant laws, directives, circulars and guidelines, which constitute the regulatory framework; (iv) relevant official pronouncements and other documentation on the supervisory framework; (v) primary evidence on the nature and extent of the supervisory practices; (vi) sundry information on the structure and development of the country s financial sector, and more specifically, the country s banking sector; and (vii) meetings with selected banks, auditing firms, and rating agencies. 3. The assessment was performed in accordance with the guidelines set out in the Core Principles Methodology, 11 and assessed compliance with the essential criteria only. Inter alia, the guidelines require that the assessments be based on the legal and other documentary evidence, in combination with the work of the supervisory authority and evidence of effective implementation of the core principles in the banking sector. Accordingly, in addition to gaining an understanding and insight into the regulatory and supervisory frameworks, the assessors also verified the application of the key elements of these frameworks, by gaining access to original evidence pertaining to onsite and offsite supervision. The assessment of the fulfillment of the Core Principles is not, and is not intended to be, an exact science. Banking systems differ from one country to the next, as do their domestic circumstances. Furthermore, banking activities are changing rapidly around the world, and theories, policies, and best practices of supervision are swiftly evolving. Nevertheless, it is internationally acknowledged that the Core Principles are seen as minimum standards. 10 The assessment was conducted from September 7 to September 21, 2011 by Pierre-Laurent Chatain of the World Bank and Joaquín Gutiérrez García of the IMF. 11 Issued by the Basel Committee, October 2006.

9 8 4. The assessment of compliance with each principle is made on a qualitative basis. A four-part assessment system is used: compliant; largely compliant; materially noncompliant; and noncompliant. To achieve a compliant assessment, all essential criteria generally must be met without any significant deficiencies, including evidence of effective implementation. A largely compliant assessment is given if only minor shortcomings are observed, and these are not seen as sufficient to raise serious doubts about the authority s ability to achieve the objective of that principle. A materially noncompliant assessment is given when the shortcomings are sufficient to raise doubts about the authority s ability to achieve compliance, but substantive progress had been made. A noncompliant assessment is given when no substantive progress toward compliance has been achieved. 5. The assessors enjoyed excellent cooperation with their counterparts, and received all the information required. The team extends its thanks to the staff of the various institutions visited and very particularly to the staff of the CNBV for their participation in the process, their hospitality, and the frankness and the accessibility provided at all times. B. Previous FSAP BCP Assessment 6. Progress in implementing the recommendations made during the FSAP Update in 2006 varies in line with the efforts made to adopt the Basel II capital regime. At that time, there were recommendations to strengthen compliance with the essential conditions of six core principles. The following paragraphs summarize progress achieved to date as presented to the assessors (Box 1). Core principle 1 on objectives, autonomy, powers, and resources: The opinion of the assessors is that the issues reported by the FSAP 2006 Update have not been effectively resolved. Moreover, there was some deterioration in regard to some of the issues (see CP1). The issues affecting autonomy, budgetary independence, and delegation of powers continue to constrain the ratings granted in this FSAP Update. Among other changes to the Ley de las Instituciones de Credito (LIC), licensing and de-licensing powers were transferred in 2008 from SHCP to the CNBV. However, the Board of the CNBV retains the final approval power. The assessors believe that, given the fact that SHCP nominates 10 out of 13 of the members of the Board, this transfer is more a formality than a substantive delegation of SHCP s powers to the CNBV. As referred to in CP1 (2), the assessors noted at least 31 key supervisory decisions where the actual decision making authority belongs to the Board of the CNBV rather than to the senior management of the agency. Core principle 5 on investment criteria: The previous FSAP Update recommendation has been addressed in many respects. In 2008, the power to approve major acquisitions in banks was transferred from the SHCP to the CNBV. The assessors believe that this reform has been a major step forward. However, it would have been

10 9 better if the CNBV had been provided with full autonomy by not requiring the favourable and binding opinion of the BoM for any transfer of ownership exceeding 20 percent. Core principle 10 on connected lending: The recommendations made in 2006 have not been fully implemented as suggested. The Executive has not succeeded in amending the LIC to reduce the maximum 50 percent aggregated lending limit with related parties and bring it closer to international standards. CNBV senior management introduced by regulation in 2011 an aggregated 25 percent lending limit with relevant related parties with a 10-year phase-in period. Amounts in excess of this are to be deducted from Tier 1 capital. Box 1. Actions Undertaken to Implement Recommendations of the 2006 FSAP Update - Realignment of powers from SHCP to CNBV (authorization and licensing procedures, authorization for the transfer of significant ownership and for investments major acquisitions by banks in nonfinancial companies, ancillary services providers). - A new regulatory deduction from TIER1 capital regarding credits to Relevant Related Parties in excess of 25 percent from said capital. This deduction applies to credits granted to persons who possess (directly or indirectly) at least 20 percent of a bank s shares, be it on an individual or collective basis. - Regarding Principle 10 Connected lending, on January 27, 2011, Accounting Standard C-3 Partes relacionadas (Related parties) issued by CNBV was updated and is now convergent to IAS 24 Related Party Disclosures issued by the International Accounting Standards Board. - Regarding Principle 20 Consolidated supervision, during 2010 and 2011 CNBV developed the Consolidated and risk based supervision project in order to evaluate the convenience of standardizing the regulation applicable to banks with that applicable to other financial entities that can be part of their financial group. As a result, it was considered that the external auditors regulation applicable to mutual funds asset managers (sociedades operadoras de sociedades de inversion) should be taken to the bank standard. Core principle 20 on consolidated supervision: The CNBV confirms that the powers for licensing and de-licensing individual institutions have been transferred from the SHCP to the Board of the CNBV (see substantive comments above for CP1). However, powers to license groups and regulate holding companies to extend consolidated regulation to a full financial group remain under the authority of the SHCP. Moreover, during this FSAP 2011 update, the assessors foresaw clear risks to the banking sector from broader unregulated mixed-activity groups, which is an issue needing serious consideration (see CP24);

11 10 Core principle 22 on remedial measures: The deposit insurance scheme has been modernized and better aligned with international standards. Mexico is still lacking a legal framework for bank liquidation. There is also a need to establish a framework and operational guidelines for the resolution of financial groups. Core principle 23 on global consolidated supervision: The legislation suggested to empower the CNBV to supervise parallel banks has not been enacted. New regulations for data processing and outsourcing have been adopted. However, all issues related to implementing upward supervision of mixed-activity and horizontal groups persist (see CP24). Institutional and market structure overview Macroeconomic background 7. Banking supervision is performed against a backdrop of a sound macroeconomic policy framework that has limited the fallout from the crisis. After a steep fall in output in 2009 owing to its close trade linkages with the United States, Mexico experienced a broad-based recovery, with a resurgence of manufacturing exports as well as renewed strength of consumption. The authorities employed a wide range of countercyclical policies, with the central bank loosening monetary policy while the government applied a careful fiscal stimulus (3 percent of GDP). 8. Other important policies were also implemented. These included foreign-exchange interventions (the first since September 1998) to control the pace of depreciation of the peso, the use of an FX swap agreement with the U.S. Federal Reserve, an FCL from the IMF to backstop net international reserves, and an additional liquidity facility allowing a broader range of eligible collateral for emergency liquidity support. In response to the surge in capital flows to emerging markets, the exchange rate appreciated by about 10 percent, yet significantly less than some other emerging markets. The record of sound macroeconomic policies is reflected in low inflation below 4 percent per annum and sound balance sheets: net public debt stands at around 40 percent of GDP in 2011, and household borrowing is about 20 percent of disposable income. As a result, Mexico has maintained its investment grade, further bolstering its resilience to shocks. 9. The policy response also relied on macro- and micro-prudential instruments. These included (i) a tightening of related-party lending for banks, which given the large presence of foreign banks in Mexico sought to gradually reduce the risk that foreign-owned banks would drain liquidity from domestic subsidiaries and add to the credit contraction; (ii) the introduction of forward-looking loan-loss provisioning for all the retail segments; (iii) a tightening of corporate disclosure on derivative positions, following large losses by the corporate sector; and (iv) the ongoing expansion of the regulatory perimeter to cover mortgage providers that faced significant liquidity problems and losses. The Bank of Mexico tightened its foreign exchange liquidity coefficient, with a view to raising the cost of bank

12 11 borrowing abroad in foreign exchange to fund lending in pesos and diminish the attractiveness of using Mexican banks as counterparties in carry-trade. 10. Despite significant structural reforms, Mexico s growth has remained low, and the financial system shallow. Between 1985 and 2008, the annual average growth in per capita GDP amounted to 1.1 percent. Low growth is partly attributed to poorly functioning credit markets, a high degree of informality in the economy, and significant market distortions related to lack of competition. Mexico also scores high on corruption indices, and the legal system is not considered efficient. Measures of financial depth point to low financial intermediation, with credit to GDP well below peer emerging market economies, at about 25 percent of GDP at end Mexico s dependence on oil exports has been in steady decline, although the budget has become more reliant on oil revenues. 11. The main risk factors for the Mexican financial system are linked to global and domestic developments. A slowdown of the U.S. industrial production would have an adverse effect on domestic economic activity and, in turn, on the demand for credit and the quality of loan portfolios. Also, adverse developments in the oil market could result in increased borrowing requirements by the public sector, with crowding-out effects. Although progress was made in extending the maturity and duration of government domestic debt, it remains relatively short term and vulnerable to a tightening of global liquidity and sharp increases in interest rates, which could lead to increased volatility in the financial system. Moreover, Mexico may also be affected by a global increase in risk aversion associated with financial distress, as well as spillovers from the global crisis, given the large presence of U.S. and Spanish banks in the financial system. Financial sector structure 12. Mexico s financial system is small and concentrated, with seven banks accounting for more than 80 percent of the system s assets. Financial intermediation and credit to the private sector are among the lowest in Latin America and well below other emerging markets of comparable income. At end-september 2011, there were 42 banks (bancos multiples), commonly divided into the following sub-groups: (i) 7 large banks, 5 of which are subsidiaries of foreign banks; (ii) 9 banks focused on consumer lending; (iii) 15 corporate banks; and (iv) 11 investment banks. 13. Other components of the financial system include: (i) public development institutions involved, inter alia, in housing and agricultural finance (6 public development banks, 7 public development trusts and funds, and 4 development agencies) these agencies account for roughly one-third of all lending; (ii) mutual funds (a total of 534 funds managed by 63 mutual fund managers are in operation at end-july 2011); (iii) one stock exchange and its broker-dealer members; (iv) savings and loans institutions and credit unions; (v) insurance companies; (vi) pension fund administrators over 70 percent of the contributions are managed by the six largest companies (and more than a third managed by two administrators

13 12 affiliated with the two largest banks); private pension funds now hold assets in excess of 12 percent of GDP; and (vii) other institutions, including non-deposit-taking credit institutions (Sofoles, Sofomes), deposit warehouses, leasing and factoring firms, and credit bureaus. 14. There are 25 financial groups, in which a holding company manages several financial entities, usually including one bank. The largest are involved in virtually all financial business (banking, insurance, asset and fund management, brokerage, and pension fund administration). This may raise conglomeration issues (i.e., large banks with an insurance company, pension fund, brokerage house, etc.) that might lead to product bundling with nontransparent cross-subsidies, deterring entry and competition. More importantly, several banks are members of broader mixed-activity groups that combine banking with commercial activities and still need to be regulated and supervised to mitigate association risks. 15. The banking system appears to be sound and profitable, and it has strengthened considerably in recent years. The financial sector was not seriously affected by the crisis. Private banks appear well capitalized, with a system-wide risk-weighted capital asset ratio of 15.6 percent as of May 2011, with Tier I capital of 13.6 percent. Profitability declined sharply in , but has recovered more recently with the improvement in loan quality, a pickup in credit growth, and rapid declines in provisions and write-offs. Following the crisis, banks have become more selective in their provision of credit cards, and outstanding balances and the number and credit limits of cards were drastically cut for the higher risk categories. Bank credit to the private sector has been pro-cyclical, but liquidity seems adequate. The loan-to-deposit ratio is moderate, and banks keep about one-third of their total assets invested in government securities. 16. Improvements in risk management have taken place. Markets for derivatives (both over-the-counter (OTC) and exchange traded) have grown significantly, allowing for better management of market risks. Banks also benefit from a broad and stable domestic deposit base, with little reliance on wholesale funds or lines of credit from parent banks. However, medium-sized and small banks appear to be much less liquid. Risk management practices in systemically important commercial banks have strengthened substantially, supported by internal models from reputable specialized vendors and the headquarters of foreign banks (where applicable). However, the large credit card losses suggest that potential credit risk and control gaps may remain. Supervisory environment 17. The regulatory regime in Mexico consists of various regulatory agencies, with some overlapping mandates. The CNBV is the banking and securities regulator, CONSAR the pension regulator, IPAB the deposit insurance agency, and the CNSF the insurance regulator. Payment system oversight is handled by the Bank of Mexico (BoM), which also

14 13 has roles in bank licensing, capital and liquidity prudential regulation, and derivatives. Foreign exchange policy is decided by the Foreign Exchange Commission a body comprising the SHCP and BoM. In 2010, the authorities created the Financial Stability Council (FSC) a cross-agency council chaired by the Minister of Finance with representatives from the BoM, CNBV, CNSF, CONSAR, and IPAB. The Ministry of Finance (SHCP) authorizes financial groups, and has a dominant presence on the governing Boards of the other agencies, except the Bank of Mexico, which is independent. 18. Legal and institutional weaknesses continue to hamper financial development, despite progress in this area. Mexico has passed key reforms, including a Unified Registry for Movable Collateral, and reforms of the Law on Bankruptcy and the Commercial Code. However, remaining weaknesses include relatively weak property rights, a complex and unreliable insolvency and creditors rights framework, an inefficient and corrupt judicial system, and insufficient transparency in financial information. These factors increase bank risks and raise the loss-given default, increasing bank spreads and restricting access, especially to small and medium-size enterprises. 19. In addition, improvements in credit bureaus and risk modeling have allowed banks, vendors, and other suppliers to better assess credit risks. However, costs of realizing collateral remain high, including for registration and because of regional discrepancies in cadastres and registries. Although the framework has improved sufficiently so that banks are confident about eventually collecting their collateral, it can still take several years to work through all the processes, and many banks prefer to write-off the debt, especially for small debtors, compensating for this by increasing the rates on loans. 20. Regarding insolvency, only 428 bankruptcy cases have been filed through February 2011 since the Commercial Bankruptcy Law was passed in Although the process has been improved and the legislation follows international good practice, the process is slow, the courts and judges need to improve, and debtors can use multiple layers of appeal to slow the judicial process further. Debtors also have little incentive to cooperate, since the system is not set up to help companies emerge from insolvency (such as by providing debtor-in-possession financing), and it is difficult to fully discharge debts through partial payment. Creditors also have little incentive to participate; those with guarantees prefer to execute their claims individually, and those without guarantees find the probability of payment too low. Given these difficulties, it appears that many smaller firms liquidate outside a formal process, which often results in the creditors closest to the debtor being paid off first. C. Principle-by-Principle Assessment 21. This assessment has been completed against both essential and additional criteria. The description and comments touch on the additional criteria where viewed

15 14 appropriate by the assessment team. However, the level of implementation of the additional criteria has not affected the overall assessment of each core principle. Table 1. Mexico: Summary of Compliance with the Basel Core Principles Core Principle C 1/ LC 2/ MNC 3/ NC 4/ N/A 5 1. Objectives, Independence, Powers, etcetera X 1.1 Responsibilities and Objectives X 1.2 Independence, Accountability, Transparency X 1.3 Legal Framework X 1.4 Legal Powers X 1.5 Legal Protection X 1.6 Cooperation X 2. Permissible Activities X 3. Licensing Criteria X 4. Transfer of Significant Ownership X 5. Major Acquisitions X 6. Capital Adequacy X 7. Risk Management Process X 8. Credit Risk X 9. Problem Assets, Provisions, and Reserves X 10. Large Exposure Limits X 11. Exposures to Related Parties X 12. Country and Transfer Risks X 13. Market Risks X 14. Liquidity Risk X 15. Operational Risk X 16. Interest Rate Risk in the Banking Book X 17. Internal Control and Audit X 18. Abuse of Financial Services X 19. Supervisory Approach X 20. Supervisory Techniques X 21. Supervisory Reporting X 22. Accounting and Disclosure X 23. Corrective and Supervisor s Remedial Powers X 24. Consolidated Supervision X 25. Home-Host Relationships X Totals (For the 25 principles) Totals (For the 6 sub-components of BCP1) / C: Compliant. 2/ LC: Largely compliant. 3/ MNC: Materially noncompliant. 4/ NC: Noncompliant. 5/ NA: Not applicable.

16 15 Table 2. Mexico: Detailed Assessment of Compliance with the Basel Core Principles Principle 1 Assessment Principle 1(1) Summary description and findings re principle 1(1) Essential criteria EC1 findings re EC1 EC 2 Objectives, autonomy, powers, and resources. An effective system of banking supervision will have clear responsibilities and objectives for each authority involved in the supervision of banks. Each such authority should possess operational independence, transparent processes, sound governance and adequate resources, and be accountable for the discharge of its duties. A suitable legal framework for banking supervision is also necessary, including provisions relating to authorization of banking establishments and their ongoing supervision; powers to address compliance with laws as well as safety and soundness concerns; and legal protection for supervisors. Arrangements for sharing information between supervisors and protecting the confidentiality of such information should be in place. Materially Noncompliant Responsibilities and objectives. An effective system of banking supervision will have clear responsibilities and objectives for each authority involved in the supervision of banks. Laws are in place for banking, and for the authority (each of the authorities) involved in banking supervision. The responsibilities and objectives of each of the authorities are clearly defined and publicly disclosed. Articles 3 to 8 of the LIC govern the activities of the banking and credit institutions and define the powers and responsibilities of the Mexican regulatory authorities, including licensing and supervision, as well as enforcement powers and bank resolution. CNBV s law defines its objectives and functions, as well as its internal organization, the composition and role of its Board of Directors, and the functions of its president. Article 18 establishes its budgetary resources and Article 20 the regime applicable to its employees. The official policies for supervision determined by the CNBV were approved in January 2005 by an ordinance ( Reglamento de Supervision ) of the President of the United Mexican States. In addition, the central bank (BoM, or BoM) law also gives certain regulatory powers to the BoM. Finally, the Instituto para la Protección del Ahorro Bancario (IPAB) law governs deposit insurance and its role in resolving failing banks. These laws and CNBV s ordinance, as well as the set of regulations enacted by the CNBV for its implementation by the industry, are very comprehensive and available for public consultation on the websites of the CNBV, the BoM, and the SHCP. The laws and supporting regulations provide a framework of minimum prudential standards that banks must meet.

17 16 findings re EC2 EC3 findings re EC3 EC4 Article 98 (Bis) of the LIC governs the general obligation of banking institutions regarding the observance of prudential regulations. It also establishes CNBV s regulatory powers. Using these powers, the CNBV issues and amends periodically a broad set of regulations, which have been compiled in the Unified Banking Circular (CUB) and cover all relevant prudential matters. The Law on Financial Groups (LAF) regulates mixed-financial conglomerates. It empowers the SHCP (see CP24) to request the relevant information in order to authorize the registration of the leading financial holding company. With the exception of the obligation of institutions to undertake their internal capital adequacy assessment process (ICAAP) and certain observations noted by the assessors in other CPs, the set of laws and supporting regulations fulfill the requirements of this EC. As a key element of the fiduciary duties and responsibilities of directors serving on the Boards of credit institutions, they must follow sound and safe practices, including respecting risk management and control regulations. But these responsibilities are not explicitly indicated in the LIC; rather, they are enunciated in the secondary regulations issued by the CNBV (notably, the CUB). The assessors believe that this might have consequences regarding the enforceability of the directors legal responsibilities in the event of breaches of prudential regulations, and most notably for failing to properly ensure the adoption and enforcement of sound risk management and control systems in their institutions. Currently, these breaches would be treated as an administrative infraction rather than as a criminal offense. The latter carries more severe consequences, which could act as a deterrent for failing to follow sound risk governance practices. Accordingly, and given that a risk based approach to supervision is predicated on a low tolerance level toward inadequate risk management and ineffective controls, the assessors strongly recommend to the authorities to consider a review of existing legislation (amending the LIC). The gravest breaches of the duties and responsibilities of directors should be treated as a punishable criminal offense. Banking laws and regulations are updated as necessary to ensure that they remain effective and relevant to changing industry and regulatory practices. The LIC has been modified 13 times since 2005 to update a variety of principles, including the procedures to resolve failed institutions, improve legal protection, implement Basel II, and develop a framework for cooperation with other local and foreign supervisors. The CNBV s regulatory norms have been continuously updated to ensure that they remain effective and relevant to the changing economic environment and regulatory practices. The CNBV does not have the power to submit legislative amendments to parliament. This power rests with the executive branch through the SHCP. The support of the SHCP representatives serving on the Board of the CNBV for legitimate legislative changes is of the utmost importance. During 2010, the political process failed to endorse the changes proposed by the CNBV to amend the aggregate lending limit for related parties set in the LIC Article 73 Bis, which is capped at 50 percent of Tier 1 capital. This is the main reason for the assessors rating of CP11 as largely compliant. The supervisor confirms that information on the financial strength and performance of the industry under its jurisdiction is publicly available.

18 17 findings re EC4 Additional criteria AC1 findings re AC1 Assessment of Principle 1(1) Comments Principle 1(2). Summary description and findings re principle 1(1) Essential criteria EC1 The Commission makes publicly available on its website a broad range of statistical information and indicators regarding the financial condition and performance of the institutions under its supervision, both on an individual and system-wide basis. In determining supervisory programs and allocating resources, supervisors take into account the risks posed by individual banks and banking groups and the different approaches available to mitigate those risks. The CNBV established in 2008 an internal committee (Supervisory Group) that performs as an internal forum for discussion and decision making. The members of this group are the president of the CNBV, all the vice-presidents, and general directors of supervision. The Supervisory Group meets every two weeks in order to: (1) review the risk-profiles of all supervised entities; (2) establish and review supervisory priorities; (3) design the Annual Inspection Program; (4) set standardized internal criteria; (5) discuss relevant cases of supervised entities; and (6) analyze systemically important issues. The frequency of inspections and other supervisory activities, as well as the allocation of supervisory resources, follow the risk profile of the institutions according to a new riskbased supervisory process summarized in a risk matrix adopted in 2007 and The CNBV pays special attention to assessing institutions and trends that might pose a significant risk to the banking system as a whole (see CP19). Largely Compliant The opinion of the assessors is that compliance with the essential and additional criteria of this CP is largely achieved, but it can be reinforced by implementing the following actions: Complete the legal framework to implement risk based supervision by explicitly stating in the LIC: a) the fiduciary role and responsibilities of directors to effectively implement all risk governance and control regulations enacted by CNBV; and b) the obligations of the Boards of credit institutions to adopt an ICAAP (see CP7); It is essential to obtain the support of CNBV s Board of Directors, notably those representing the government, for the legal reforms proposed by CNBV s senior management. Independence, accountability and transparency. Each such authority should possess operational independence, transparent processes, sound governance and adequate resources, and be accountable for the discharge of its duties. The operational independence, accountability and governance structures of each supervisory authority are prescribed by law and publicly disclosed. There is, in practice, no evidence of government or industry interference which compromises the operational independence of each authority, or in each authority s ability to obtain and

19 18 findings re EC1 EC2 findings re EC2 EC3 findings re EC3 deploy the resources needed to carry out its mandate. The head(s) of the supervisory authority can be removed from office during his (their) term only for reasons specified in law. The reason(s) for removal should be publicly disclosed. CNBV s governance, powers, accountability and supervisory authority are derived from its law. Being part of the Federal Government, the CNBV is subject to surveillance and control by the Secretariat of Civil Service ( Secretaría de la Función Pública - SFP). The CNBV is a decentralized body of the Secretaria de Hacienda y Credito Publico (SHCP), with formal technical autonomy and executive powers (CNBV s Law, Article 1). CNBV s Board has 13 members, of which the SHCP has direct authority to nominate or remove 10 members at its discretion, including the President of the Commission. By Law, the president of the CNBV is appointed by the SHCP, and its vice-presidents and general directors are appointed by the Board upon the president s nomination. The length of the term of office of the president, vice-presidents and directors of the CNBV is not specifically stated; nor are the reasons for their removal stated in the law. The reasons for removal need not be publicly disclosed. Regarding the CNBV s de facto independence, the assessors note that, in spite of recent efforts to transfer the powers for licensing to the CNBV, most of its key decisions as supervisor require approval by the Board, which leaves the decisions of the CNBV open to influence by other policy goals. The assessors note that in 31 cases the CNBV senior management has taken major decisions in line with the LIC, but these have needed subsequent approval by CNBV s Board, including 12 cases where the opinion or concurrence of the BoM has also been required. The supervisor publishes objectives and is accountable through a transparent framework for the discharge of its duties in relation to those objectives. CNBV s objectives are defined in its law (Article 2) and guide its overall operations. The CNBV publishes an annual report of its activities and is held accountable through the oversight powers of the General Audit of the SHCP and the SFP. The CNBV would like to make public to the industry its supervisory review and evaluation process (SREP), as well as the core criteria that will guide its activities and key decisions. This should include the response and escalation regime that the CNBV intends to follow in order to reduce the risk profile of the institutions going forward, before adopting formal enforcement and resolution measures. The supervisory authority and its staff have credibility based on their professionalism and integrity. CNBV s staff has continued to gain credibility among market participants based on high professionalism, competence, and integrity. There is agreement that CNBV s capacity has improved notably in recent years, although more experience and training in supervisory functions are still needed. Market participants expect to receive further detailed guidance regarding the expectations of the CNBV for risk governance (e.g., risk appetite), as well as to understand better the detailed criteria applied in reaching a judgment about the effectiveness and adequacy of certain risk management processes. Participants would like to see all the elements of Basel II implemented before moving to the implementation of the Basel III reforms.

20 19 EC4 The supervisor is financed in a manner that does not undermine its autonomy or independence and permits it to conduct effective supervision and oversight. This includes: A budget that provides for staff in sufficient numbers and with skills commensurate with the size and complexity of the institutions supervised; Salary scales that allow it to attract and retain qualified staff; The ability to commission outside experts with the necessary professional skills and independence and subject to necessary confidentiality restrictions to conduct supervisory tasks; A training budget and program that provides regular training opportunities for staff; A budget for computers and other equipment sufficient to equip its staff with the tools needed to review the banking industry and assess individual banks and banking groups; and findings re EC4 A travel budget that allows appropriate on-site work. The SHCP determines the annual budget of the CNBV according to Article 16, XI of its Law. This determination is made within the envelope communicated by the SHCP to the CNBV. Such budget is not necessarily aligned with the actual needs of the Commission. A supervisory fee is levied every year on the supervised institutions, as determined by the SHCP. Such fee is calculated based on the total assets of each institution. The basis for calculating the fee does not yet take into account the particular risk profile of each institution, which, as currently evaluated by the CNBV, identifies the difficulties associated with and the intensity of supervision actually required for the various institutions. The SHCP receives directly the proceeds collected from the fees levied and allocates to the CNBV between 70 and 80 percent of the total fees collected to cover the CNBV s overall current and investment expenses. However, the budget assigned is very inflexible, as it must be applied to the various categories of expenses approved ex-ante by the SHCP. CNBV s senior management does not have budgetary discretion to re-allocate the budget to changing and possibly new urgent needs throughout the year. Box Selected indicators CNBV Indicators Budget to Total Assets 0.021% 0.017% 0.017% 0.017% 0.016% Expenses to Total Assets 0.005% 0.003% 0.005% 0.006% 0.006% Salaries to Total Assets 0.016% 0.014% 0.011% 0.011% 0.010% Salaries to Budget 77.2% 82.6% 67.8% 64.5% 65.0% Salaries to Staff Headcount (1) Total assets to Headcont (1) 4,150 4,469 5,184 4,803 5,578 (1) in mill. of MXP Currently, the budget allocated by the SHCP to the CNBV is not sufficient to cover the latter s operational needs. In particular, the budget is insufficient to attract, train, and retain the high-quality staff required to face the challenges of operating a modern supervisory agency (see Box of Selected Indicators). Salaries have remained frozen for the last 7-8 years for professional staff. As a consequence, the salary gap with the private sector has risen and the turnover of senior staff increased in 2010 (see table). CNBV Board members from BoM have shared this concern in Board meetings and with the FSAP mission.